Industrial Organization

1
Industrial Organization

• Vertical Structures

2
Vertical Structure

• So far firms sell directly to consumers
• In many cases

c
Upstream (e.g. manufacturer, farmer)
Pw
Downstream (e.g. processor, retailer)
PR
Demand qf(PR)
3
Vertical Structure

• Why vertical separation?
• Efficiency
• Upstream unit can specialize in manufacturing
• Downstream unit can specialize in retailing
• Legal
• Vertical integration is often seen as
  anticompetitive. Separation is mandated by law

4
Vertical Structure

• Why not Vertical Separation?
• Manufacturer does not control all variables
  directly (e.g. promotion, quality, service,
  price)
• Inefficiencies
• If both upstream and downstream firms have some
  market power, solution is inefficient (double
  marginalization)
• Contract costs, monitoring, negotiation
• Opportunistic behavior (e.g. free riding by
  retailers)

5
Vertical Structure

• Why not Vertical Separation?
• Retailers objectives not aligned with
  manufacturers
• Other
• Assure supply (hold up problem)
• Example sugar production in Slovakia
• Price discriminate (e.g. aluminum)

6
Vertical Structure

• Suppose q1-Pr
• With Vertical Integration (VI)

7
Vertical Structure

• Vertical integration

PVI
Dr (Demand)
C
MRr
Q
QVI
8
Double Marginalization

• Vertical separation inefficient if market power
  at both levels
• Case 1 Retailer has no market power. PrPw.
  Wholesalers profit maximization problem becomes
  the VI problem
• Case 2 Wholesaler has no market power. Pwc.
  Retailers profit maximization problem becomes
  the VI problem.
• Case 3 Neither has market power. Then
  competitive solution Prc regardless of VI or
  vertical separation (VS)

9
Double Marginalization

• Set up
• Wholesaler (upstream)
• Retailer (downstream)

Wholesale price
Retail price
Retailers only cost
10
Double Marginalization
Two-stage game
Retailer (2nd stage)
Wholesaler (1st stage)
11
Double Marginalization

• Plug pw back into retailers solution
• We want to compare VI and VS

12
Double Marginalization

A
B
Pr
C
D
PwCr
PwPVI
Dr (Demand)
E
F
G
Cw
Dr
MRrDw
MRw
Q
QVS
QVI
13
Solutions to Double Marginalization

• Franchise fees
• Upstream firm sets pwc
• Downstream sets prpiv
• Upstream firm charges franchise fee
• Resale Price Maintenance (RPM)
• Upstream firm forces downstream firm to charge
  the VI price
• Quantity is set at the VI level

14
Franchise Fee

A
B
PVI
Demand
E
G
PwCwCr
MRwMRr
Q
QVI

• Franchise fee PVIBEG

15
Franchise Fee

• Retail price and quantity correspond to VI
  solution
• Downstream unit generates zero profit
• Total welfare increases
• Examples
• McDonalds, Starbucks

16
Resale Price Maintenance

?r
?w
RPMPVI
Pw
c
Demand
MR
Q
QIV

• Downstream firm sells at PVI
• Upstream firm sets Pw between c and PVI
• Profits are split based on Pw location

17
Agency and Efficiency Problems
Manufacturer (Upstream)
Pw
D1
D2
Demand qf(PR)

• Sharing the market may mean less investment (or
  none at all)
• Free riding
• Service, promotion, quality, are public goods

18
Agency and Efficiency Problems

• More free riding
• Downstream firm can use upstreams investment in
  other activities (e.g. selling more profitable
  brands)
• Upstream firm under-invests because of
  anticipated oportunistic behavior

19
Agency and Efficiency Problems Solutions

• Usually called Vertical Restrictions
• Exclusive Distribution downstream firm can only
  sell upstreams products (none from the
  competition)
• Exclusive Territories downstream firm is
  granted a monopoly within a predetermined
  geographic region (not allowed to sell anywhere
  else)
• For retailers guaranteed radius
• Resale price maintenance (RPM) all downstream
  firms are supposed to sell at same (minimum)
  price

20
Exclusive Distribution

• Key Downstream unit must make sure demand is big
  enough
• Solves incentive problem
• Upstream firms investments are protected
  equipment, training, etc
• Objectives are aligned downstream firm focuses
  effort on upstream firms products only
• Upstream firm increases investments
• This decreases distribution costs (better
  equipment, training, etc.)
• Enhanced consumer demand

21
Exclusive Territories

• Aligned incentives
• Quality of service is no longer a public good
• Demand level is guaranteed this provides larger
  investment incentives for distributor
• May enhance consumer surplus
• Better service quality stimulates demand
• Wider selection of products
• With no exclusive territories there can be
  under-provision of products

22
Example US Brewing Industry
D
D2
23
RPM

• Maximum RPM
• Avoid DM problem
• Concern retailers may think this is unfair
  (insufficient margins)
• Minimum RPM
• Avoid free riding problem
• Concern consumers facing higher prices

24
Anticompetitive Behavior?

• Antitrust authorities may not like these
  contracts (VR)
• Exclusive territories may increase downstream
  firms market power by reducing intrabrand
  competition
• Exclusive distribution
• May exclude smaller downstream firms
• Force use of less efficient channels
• RPM related to price fixing in horizontal case
  upstream firm more market power?

25
Anticompetitive Behavior?

• However positive effects too
• More efficient downstream firms in the presence
  of exclusive dealing (lower costs from higher
  upstream investment)
• More investment in the presence of exclusive
  territories
• RPM eliminates double marginalization
• Enhanced provision of services (increased
  consumer welfare) with both ET and ED